TIPS Suggest Inflation to Drop as Commodity Bubble Bursts

Treasury Inflation-Protected Securities (TIPS) now have an embedded inflation of 2.9 percent over the next 12 months, about 25% less than the current rate of 4%. Bond traders are therefore as optimistic as the Fed that inflation will soon drop.

Interestingly, the difference in the inflation expectations of the average person and the expectations of the TIPS market has reached its highest level since the bonds were introduced in 1997. Bloomberg:

Consumers expect prices to rise 5.2 percent in the next 12 months, according to a monthly survey by the University of Michigan in Ann Arbor, the most pessimistic they've been since 1982. Treasury Inflation Protected Securities, or TIPS, show traders anticipate inflation of about 2.9 percent by January, in line with its average of 3.1 percent the last 20 years.

The disparity has never been wider. While consumers grapple with gasoline above $3.70 a gallon, record rice prices and the escalating cost of wheat, TIPS say the commodities market is a bubble about to burst.

The growing gap suggests that the inflation picture may not be as serious as we think and may improve as cooling demand takes pressure off prices and speculators retreat from a deflating commodities bubble.